Griffith experts comment on banking royal commission

The release of the final report on the recently concluded royal commission into banking misconduct has highlighted several areas of concern within the Australian financial services sector, with far-reaching implications for consumers and institutions alike.

Unbridled desire to make a sale or profit at any cost and the bank executives’ remuneration schemes linked to profit were at the centre of the much-publicised malpractices of the banking industry.

“Greed” is the word used by the royal commission in describing the conduct of the banking, superannuation and financial services industry. Otherwise, how can one explain charging fees for services not provided? How can one explain fees charged to dead people?

The Australian banking industry has been politically very successful in recent decades. During the GFC, the government of the day provided financial guarantee to deposit-holders for preserving public trust in the banking system. It was long thought that the Australian financial regulatory system is one of the best in the world. There was also a tacit acceptance in the Australian community that a strong economy needs a strong banking industry. So when the cost of funds kept rising in the international markets in the post-GFC years, banks found a solid excuse for raising their lending interest rates asynchronous to the RBA’s interest rate decisions.

Consequently, when the average home-loan borrower felt the pressure from rising bank interest rates, they were told by the government of the day to “switch banks”. Meanwhile, Australian banks learnt their ways of making money through service charges and fees. For example, starting with $27.06 billion in FY 2013, the four major banks’ aggregate after-tax cash profit reached a record high of $31.5 billion in FY 2017. The average net interest margin on a cash basis for these banks was 200 basis points or more over the FY 2013-2018 period. Ironically, nobody raised their eyebrows when the four major banks reported record profits despite crying poor about the rising costs of funds in the international markets.

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The desire to survive and excel under tough global conditions perhaps resulted in a culture of performance in the banking industry. Profit and revenue became the gold standard of performance in banks. Moreover, in the pursuit of delivering performance and creating shareholder wealth, executive remuneration schemes were linked to performance. The desire to perform better and aim for excellence sounds ideal in theory, but this can also lead to the pursuit of profit at any cost, which in turn informs employees what the firm values. This is central to the misconduct in the banking industry.

In markets for tangible goods and everyday services (like cutting hair in a barber shop), the customer is relatively well informed. The customer can readily verify whether they have been conned or not. But with complex products like banking and financial services, the average customer is far less informed. It is virtually a David and Goliath battle: the naïve bank customer against the sophisticated bank with all of its superior information set, advanced analytical tools, and sharp legal minds.

There is no way the naïve customer can get a “fair” deal unless the customer is protected by the law. The only other hope for the bank customer is whether the bank believes in a “fair go”, whether the bank employees behave ethically, and in the best interest of the customer. This will require a moral shift – an attitude to be fair. Such a change in attitude cannot spring out of the bottom. It has to come from the top.

The final report of the commission clearly outlines that the primary responsibility of this misconduct fiasco lies with those who manage and control the banks: top management and the board of directors. The commission, in many instances, found the relevant boards did not get the right information about operations and non-financial risks, did little to obtain adequate information, and did nothing much to question or challenge management on such risks. Clearly, they have not been as effective as they should have been in carrying out their duties.

The obvious question is: shouldn’t board accountability and responsibility extend beyond shareholders to customers and other stakeholders? The commission touts for self-regulation and recommends financial services entities improve their culture and governance through continuous assessment, identification and dealing with any problems of that nature, but does little to punish the boards of those entities that were found involved in the misconduct. This is perhaps one of the biggest shortcomings of the report.

The final report of the Hayne royal commission delivered some big recommendations for superannuation, although they aren’t all new ideas.

Broadly, the recommendations for superannuation can be split into two areas – those aimed at protecting members’ interests, and those related to the governance and regulation of superannuation.

For members’ interests, the recommendations seem pretty straightforward, such as restrictions and limitations on deducting advice fees unrelated to superannuation interests from member accounts.

Perhaps the recommendation with the biggest impact is that members only have one default account, although this was previously recommended in the Productivity Commission’s report on the efficiency and competitiveness of our superannuation system.

Linked to default superannuation, Hayne’s report also recommended prohibiting trustees from treating employers, a practice which see funds courting employers – such as Hostplus spending $260,000 on tickets to the Australian Open for 120 employers.

In terms of governance and regulation, a recommendation was made to restrict the roles or offices that trustees could hold, so they can no longer wear ‘two hats’. The final recommendation is for civil penalties for breach of covenants and like obligations, so if a trustee breaches their duty to, for example, act honestly and in good faith, there will now be an enforceable penalty.

While generally sensible and well thought out, many of these recommendations will not be welcomed by the superannuation industry. It will be interesting to see Labor’s response and what happens from here.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry identified numerous instances of misconduct by financial services entities, which include banks, financial planning and advisory licensees and practices, as well as their representatives. ASIC is the government agency which serves as an educator, administrator, advisor, investigator and enforcer of laws which regulate financial services. ASIC’s role as an enforcer was the focus of the royal commission’s final report.

Commissioner Hayne was critical that the laws regulating financial services entities were not enforced, or not enforcement effectively by ASIC (at p.3):

… too often, financial services entities that broke the law were not properly held to account. Misconduct will be deterred only if entities believe that misconduct will be detected, denounced and justly punished.

Effective enforcement deters misconduct, and deterrence requires “visible public denunciation and punishment” (p. 433). The severity of the punishment needs to fit the misconduct (or crime), and the misconduct publicised and condemned.

Commissioner Hayne’s concern was not about the availability of ASIC’s enforcement tools, but rather their choice and application by ASIC to achieve the purpose of deterring misconduct.

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Commissioner Hayne recommended that ASIC should adopt an approach to enforcement that: begins with the question of “whether a court should determine the consequences of a contravention” (p. 37-38), or “why not litigate?”; utilises infringement notices primarily for “administrative failings” involving entities other than large corporations; and focuses on deterrence in deciding whether to accept an enforceable undertaking.

Infringement notices and enforceable undertakings, being out-of-court procedures that are published on an ASIC register and summarised in a media release, may not have the same deterrent effect as court actions in which civil or criminal action is pursued in public, and where the punishment for misconduct is likely to be greater.

For example, ASIC has accepted enforceable undertakings from financial services entities that charged clients fees but did not provide any services in return. Despite the enforceable undertakings, as well as a report by ASIC that it was investigating multiple instances of ‘fee for no service’, some financial services entities were still engaging in this practice.

Consistent with Commissioner Hayne’s recommendations, I would envisage more civil and criminal actions involving financial services entities in the short to medium term. In fact, Commissioner Hayne referred ASIC to two financial services entities that may have breached section 1041G of the Corporations Act, which makes it a criminal offence to engage in dishonest conduct in relation to a financial product or service. Specifically, the conduct related to ‘fee for no service’.

However, a greater focus on civil and criminal action for ASIC requires more government funding. The public denunciation of financial services entities arising from the proceedings of the Royal Commission, combined with the Final Report, could be used by ASIC to lobby the Federal government for additional funding in an election year. A corporate watchdog that is sufficiently resourced to publicly beat the ‘villains’ of the financial services industry may serve both legal and political objectives.

By exposing poor financial sector behaviour and making 76 recommendations to remedy those that came to light, Commissioner Hayne’s final report will hopefully result in cultural change and a much improved banking and financial system that is more ethical and customer-focused.

Financial systems in advanced economies have characteristics, such as the asymmetry of information between savers/lenders and borrowers/investors, as well as fractional reserve banking, that set them apart from other markets/industries in the economy governed primarily by the normal forces of supply and demand. For that reason, government regulation of banking and finance becomes necessary, although by how much has long been an issue for economic debate.

A key lesson from the inquiry was that not only banks but the existing government regulators, ASIC and APRA, had failed. So a new overarching regulatory body recommended in the report is to be welcomed. That may, however, imply more effective, not necessarily more, financial regulation overall.

From a macroeconomic perspective, there is the risk that policymakers overreact to the Hayne recommendations and over-regulate, especially in relation to the big four banks, turning already-tightened credit conditions currently affecting property markets Australia-wide into a “credit crunch”. That would adversely impact Australian businesses and households and increase the risk of recession, defined as two successive quarters of negative growth measured on an income per head basis.

The insurance-related recommendations signal a more serious approach to meeting the needs of consumers, improving transparency and fairness and, most importantly, resolving known issues that have existed for some time.

For example, enforcing a time delay between point of sale and the offering of ‘add-on’ and consumer credit insurances is a win for consumers. ASIC investigations have shown ‘add-on’ and consumer credit insurances to be poor value, with high costs and low payout rates. It’s important to recognise that while consumers are excited about their latest purchase such as a car or electronic goods or taking out loans or credit card debt that they are vulnerable and may accept policies whether or not they want them or need them.

Some recommendations were expected by the public after exceptions to insurance commissions remained following the Future of Financial Advice reforms. The proposed delay in winding down commissions may be perceived as too soft, but this allows consumers time to adjust to further increased upfront insurance advice costs, which impact on the affordability of insurance.

When it comes to claims, sure, there are those involved in insurance fraud, but many honest consumers are caught out by having forgotten to provide historic information or not believing certain information to be relevant to their insurer. Moving from a duty of disclosure to a duty to take reasonable care not to make a misrepresentation to an insurer puts more responsibility on insurers to ask the right questions, a step taken in the UK six years ago.

These and other important changes such as the anti-hawking recommendations are necessary in rebuilding trust between insurers, advisers and their communities. We’ll likely see some players exit the market, yet others take the opportunity to innovate – another consumer win.

Is the Hayne banking Royal Commission a watershed moment or does it avoid structural reform? The Final Report of the Hayne Royal Commission points to failings in corporate governance, culture and ethics in the finance sector. Furthermore, Australian regulators have been found wanting when it comes to regulatory enforcement and compliance.

There will be many winners and losers in the post Royal Commission era in 2019 and beyond. Good corporate governance and a stronger ethical dimension can aid to restore the community’s trust in the finance sector.

Griffith University will host an industry breakfast on Friday 22 February to discuss these issues and the way forward for the Australian financial services sector.

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